ECB Vice President Discusses Evolution of Stress Testing in Europe

ByRegulatory News

At the annual US-EU Symposium in Frankfurt, the ECB Vice President Luis de Guindos discussed the evolution of stress testing in Europe, also highlighting the ongoing discussions on long-term strategy for the use of micro- and macro-prudential stress tests. He focused on two key facets of this evolution: the more integral use of the top-down review process and the advantages of adding a macro-prudential perspective to stress testing. He also emphasized that it may be worth regularly publishing the results of the top-down, macro-prudential stress tests, possibly alongside the results of the micro-prudential exercise. This simultaneous publication would provide stakeholders with a more solid and comprehensive overview of the resilience of the banking sector.

The ECB Vice President highlighted that, in Europe, the stress tests offer important inputs for the Supervisory Review and Evaluation Process (SREP) of ECB. Rather than finishing with a pass or fail assessment, stress tests provide a starting point, both for discussions between banks and supervisors and for macro-prudential policymakers. The EU-wide stress tests involve significant input from the banks, following a constrained bottom-up approach. In addition to describing the constrained bottom-up approach, he explained certain drawbacks of this approach. For instance, the static balance sheet assumption limits the realism of the exercise as it does not account for how banks would respond under stressful situations. Certain caps and floors in the stress test methodology may compromise the realism of the stress test outcome. The approach also provides banks with substantial leeway to materially underestimate their vulnerability to adverse circumstances—to "game" the exercise, in other words. Consequently, the European supervisors conduct a thorough quality assurance of banks' bottom-up stress test results to ensure that their outcomes are credible. This includes confronting banks with independent model-based estimates—"a so-called top-down model challenge." This process generally leads to individual banks revising their stress test outcomes before publication.

Mr. Guindos believes that there is substantial value in this extensive supervisory scrutiny and in the improved market discipline stemming from the European stress test framework. He added that discussions about the long-term strategy for the stress tests in Europe are underway, at both the ECB/Single Supervisory Mechanism and the EBA levels. Proposed changes aim to improve the realism of stress test outcomes while retaining their reliability and credibility. He then focused on one key aspect of the proposed changes, namely the importance of top-down models, in the context of the European prudential stress tests. The top-down model challenge, which has so far taken the form of a dialog between supervisors and banks, could play a greater role in disciplining banks and reducing the incentives for them to systematically underestimate their vulnerabilities, said the ECB Vice President. This could be achieved by publishing the top-down view of supervisory stress tests, which will provide market participants with a benchmark against which to judge the results of each bank. The results could be published in individually, in aggregate form, or in ranges such as grouping banks into solvency categories that could be compared with bottom-up, bank-by-bank results. There is also a range of model-based results that could be produced and published.

Next, he discussed the advantages of taking a macro-prudential perspective with stress testing and described the key elements that characterize macro-prudential stress testing. Developing the models and infrastructure for these tests enables supervisors and regulators to analyze a range of scenarios, helping them to better understand the links between banks, other parts of the financial sector, and the wider economy. This also means that they are able to see how the banking sector reacts to a number of alternative macro-prudential policy paths, helping them to ensure that the macro-prudential measures in place remain appropriate and adequate. Additionally, there are benefits from conducting both micro-prudential and macro-prudential exercises simultaneously. A combined exercise would help banks, market participants, and regulators to assess the system-wide consequences of reactions of banks to situations of stress, which would complement the information retrieved from the micro-prudential stress tests.